Under the Surface, It’s a Bull Market

Another day, another snooze fest in late summer trading in the US. Clearly, all the big hitters are swanning about in the Hamptons. They’ve left the trading robots in charge, and set the trading frequency to low.

The Dow closed 0.13% higher, while the S&P 500 rose 0.22%. Gold continues to consolidate its strong recent gains, but it isn’t doing much either.

Oil is probably the most interesting market right now. Brent crude jumped 2% overnight and is back above US$50 per barrel. According to the pundits at Bloomberg, the rally sent oil into a new bull market.

The same pundits proclaimed oil in a bear market just a few weeks ago after it fell from nearly US$53 per barrel to a low of US$41.50. But as soon as the media’s definition of a bear market kicked in, a rally got underway.

The moves in the oil price this year have baffled me. The near 100% rally from the January low to the June high was a big one. I expected a decent correction from that point, but it was relatively short-lived. From the June peak, oil fell around 20% in two months.

But as you can see in the chart below, the price rebounded sharply, and is now back above US$50 per barrel. Will oil continue to rally beyond the June high at US$52.80 per barrel? Or is this just part of a longer term consolidation and trading range after the big rally during the first half of the year?

My guess is the latter; although I stress that it’s only a guess. For some reason I don’t get the vibe of the oil market. It’s never been a market that I’ve been very good at picking. And I’ve never been an investor in the sector either.

The massive investment in liquid natural gas projects in Australia over the past few years are a great example. Nearly all of these projects got the go-ahead when oil traded for more than US$100 per barrel.

All the major players got involved. And it was a decision that has wrought share price devastation across the board.

Even the former staid and conservative Origin Energy [ASX:ORG] got in on the act. It increased debt to dangerously high levels when investing in the near US$25 billion Australia Pacific LNG (APLNG) project in Gladstone, QLD, in partnership with ConocoPhillips and Sinopec.

In 2014, the share price hit $16. Now, the misallocation of capital is all too obvious. The share price is just under $6, after rallying from a low of $3.50 earlier this year.

Yesterday, ORG reported a headline loss for the 2016 financial year of $589 million, largely thanks to write-downs on APLNG. Underlying profits of $354 million represented a 40% year on year decline.

But the share price had factored all this in already. As I pointed out yesterday, the market looks to the future, not the past. Absent a continuing oil price rally, the future still looks bleak for ORG. Put simply, it’s carrying too much debt.

In order to get debt down to manageable levels, ORG shelved its dividend yesterday and continues to pursue asset sales. The market is also hoping that it will demerge the APLNG project into a separate entity. The rationale is that ORG’s energy distribution assets will have a much higher market value if they’re unencumbered by a low returning and volatile LNG project.

If that is the case, what was the rationale for taking on the project in the first place? An expectation of high oil prices forever? That’s hardly an endorsement of the board’s investment nous.

But it’s not all gloom and doom out there. In fact, there’s a solid bull market going on across many sectors. The weak performance of the banks is masking this bull market, owing to their large weighting in the ASX 200.

For example, have a look at these next few charts. The first one shows the performance of the ASX 200 financials index. This includes the banks, insurers and other financial stocks. Since the start of the year, the index has actually fallen.

Or what about consumer discretionary stocks? Glenn Stevens’ historic rate cuts have to go somewhere, and the ‘wealth effect’ from higher house prices has translated into strong consumer spending, as the chart of the ASX 200 Consumer Discretionary index below shows.

In fact, large parts of the market have done so well in 2016 that I’m inclined to think that a correction is looming. I’m seeing money move into many lower quality stocks. This is a sign of latecomers looking for ‘bargains’, but the only ‘cheap’ stocks left are the ones that deserve to be.

I certainly don’t think the market is going to collapse anytime soon. But a decent shakeout might not be too far away. Outside of the banks, the general mood is getting a little too bullish for my liking. Given the very weak foundations of the economy, I’m not getting too excited.

The bull needs to calm down a bit. With the volatile month of September around the corner, there might be a ‘bull-calming’ selloff in the market on its way.

Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market.
To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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